Business

School of Computer & Information Sciences

ITS 835

Chapter 23, “Control Complacency Rogue Trading at Société Générale”

This is a narrated presentation.

Overview

• Kerviel’s Trail – A Media Circus

• Société Générale – The Rise of Trading

• Jerome Kerviel

• Discovery, Damage Control, and Retribution

– Postmortem

– Managerial Supervision

– Control Environment

– System Reliability

– Risk-Sensitive Culture

• What Actually Happened

Kerviel’s Trail – A Media Circus

• Criminal trial of 33-year Jerome Kerviel started in Paris’s Palais de Justice. Charges were forgery,

abuse of trust, and illegal use of computers. Caused losses to Société Générale’s losses and the

commencement of the trail, media attention was at a high because Kerviel claimed he was a

scapegoat for high-risk trading practices that were condoned by Société Générale when profitable.

• Société Générale maintained that Kerviel was a rogue trader who single-handedly developed

methods to conduct unauthorized trading without being detected and used them to take massive

trading positions that ultimately backfired when markets turned against him.

• Global financial markets were slow recovering from the 2008 crisis, but memories of Société

Générale trading losses remined vivid because at the time of its announcement in 2008 the incident

seemed to confirm investors’ worst fears that banks in general were taking massive amounts of risk

far beyond their traditional lines of business.

Société Générale – The Rise of Trading

• Société Générale, 1999 through 2006, had a net income increase of 164 percent from €2 billion

annually to €5.2 billion. Its retail and investment management businesses both prospered during this

period, with the main drivers of this higher profitability was its Corporate and Investment Banking

(CIB) division, whose net income increased 230 percent, from €708 million annually to €2.3 billion.

• Société Générale was not alone pursing growth in the early 2000s through expansion of its trading

and capital markets business. Its larger rival, BNP Paribas, adopted the same strategy, as did other

major banks in other countries such as the United Kingdom, Germany, and United States.

• With other major, this strategy backfired when their fixed income desks became deeply involved in

structuring, selling, and trading credit derivatives and debt securities backed by U.S. residential

mortgages and were unable to avoid massive write-downs and funding crises when global credit

markets seized up in the second half of 2008.

Jerome Kerviel

• Kerviels position in Société Générale CIB was unlikely to be noticed because he was one of seven

traders in the Delta One Listed Products (DLP) team, a part of the Equity Finance section in the Equity

Arbitrage group of the CIB’s Global Equities & Derivative Solutions (GEDS) business unit.

• GEDS volatility traders were charged with profiting from directional trading positions, while the

arbitrage traders looked to profit from long/short combinations of offsetting positions by capturing

mispricing between assets with similar market sensitivity. A common feature of arbitrage trading is

that price differentials are typically very small, which requires large notional amounts of offsetting

trades in order to capture meaningful profits.

• Kerviel began experimenting with directional positions during his first year as a Delta One trader,

creating small index futures and cash equity positions that he closed out before the end of each day.

He ventured into overnight trading, but €10 million overnight cash equity position few concern in

2005. To go unnoticed he began creating fictitious trades to offset DLPs books.

Discovery, Damage Control, and Retribution

• 2008 Kerviel resumed his unauthorized directional trading, confident in his ability to keep calling

market movements correctly and hiding his profits. Convinced that the European stock market would

extend their November rally into 2008, he began a series of unauthorized equity index future

purchases that reached a new peak of €49 million.

• His strategy was able to unravel because of an administrative, not operational, slip. Kerviel changed

the counterparty of the fictitious trades concealing his 1.5 billion profits from Société Générale

affiliate to an unsuspecting third-party counterparty. However, the counterparty selectd did not have

a collateral agreement in place with Société Générale which triggered a massive overage in the

counterparty’s credit value at risk (CVaR) limit.

• Queried by risk management, Kerviel canceled the fictitious trades and created a provision in order to

keep his 2007 profits. He calculated an amount for the provision that would leave 15 million of his

undisclosed profits to be accounted for in DLPs 2007 yearbook-end trading results.

Postmortem

• Internal and external investigation into how Société Générale management and control environment

allowed Kerviel to conduct his unauthorized trading revealed a range of failing.

▪ Managerial Supervision

▪ No explicit requirement to monitor cash movements.

▪ Control Environment

▪ No limit on notional transaction volumes or cash movement

▪ GEDS’s office support for DLP was separated into four different operations groups.

▪ System Reliability

▪ Faculty security protocols allowed to continue to access and change system records after

employees changed departments.

▪ Risk-Sensitive Culture

▪ Identified cultural deficiencies, specifically DLP’s trading oversight and control personnel were

not trained or instructed to be alert for fraud and were slow and lax in responding.

What Actually Happened

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